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Debenhams - Richard Parry

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Debenhams - Richard Parry

  1. 1. DEBENHAMS: A CASE STUDY by Mr. Richard H. Parry MEng (Hons.) Oxon. A thesis submitted in partial fulfillment of the requirements for the degree of Sloan Fellowship MSc. London Business School 2006 Approved by ___________________________________________________ Supervisor __________________________________________________ __________________________________________________ __________________________________________________ Program Authorized to Offer Degree _________________________________________________ Date __________________________________________________________
  2. 2. LONDON BUSINESS SCHOOL ABSTRACT Debenhams: A Case Study by Mr. Richard H. Parry MEng (Hons.) Oxon. Supervisory: Professor Eli Talmor Department of Accounting A thesis presented on the case study of a private equity investment in Debenhams by the Baroness Retail Consortium: a consortium that includes the private-equity groups CVC Capital, Texas Pacific and Merrill Lynch PE
  3. 3. Figure 1: Debenhams: Britain’s Favorite Department Store i
  4. 4. TABLE OF CONTENTS List of Figures.....................................................................................................................iii List of Tables.......................................................................................................................iv Acknowledgments...............................................................................................................v Executive Summary...........................................................................................................vi Chapter I: The History of Debenhams....................................................................1 Chapter II: The Private Equity Firms ......................................................................8 Chapter III: The Leveraged Buyout Model ..........................................................12 Chapter IV: The Transaction Timeline,, .................................................................21 Chapter V: How Baroness Won the Bid...............................................................27 Chapter VI: Baronesses Investment in Debenhams...........................................49 Chapter VII: The Debenhams IPO and The Performance of the Buyout.....58 Chapter VIII: Conclusion.........................................................................................76 Glossary...............................................................................................................................78 Appendix A: Pre-2003 Acquisition Stock Price.....................................................1 Appendix B: Abridged Profit and Loss Accounts – UK GAAP........................2 Appendix C: Abridged Balance Sheets – UK GAAP...........................................3 Appendix D: Funding Debt – UK GAAP..............................................................3 Appendix E: Effective Interest Rates.......................................................................4 Appendix F: Abridged Cash Flow Statements – UK GAAP..............................5 Appendix G: Director and Non-Executive Directors..........................................7 Appendix H: Source of Deal Value Creation.......................................................12 Appendix I: Debenhams Estimated ROCE Analysis........................................13 ii
  5. 5. LIST OF FIGURES Number Page Figure 1: Debenhams: Britain’s Favorite Department Store ......................................i Figure 2: Debenhams: UK Department Store Sales (Source: Company data).......3 Figure 3: Debenhams: FY 2005 Sales Mix (Source: Company data)........................4 Figure 4: Debenhams: Designers at Debenhams Sales (Source: Company data)..4 Figure 5: Debenhams: Own bought versus Concessions Mix (Source: Company data)........................................................................................................................5 Figure 6: ROCE Analysis of a fictional company; Flexible Connections..............17 Figure 7: Reaching New Heights...................................................................................26 Figure 8: Laragrove Offers Capital Structure..............................................................28 Figure 9: Relative Performance of UK Mixed Goods Retailers by Size (UK Office of National Statistics) ...........................................................................34 Figure 10: Baroness Bids Senior Management Team................................................35 Figure 11: Baroness Capital Structure for the 455p bid............................................38 Figure 12: Baroness Capital Structure for the 477p bid............................................44 Figure 13: Nectar Rewards Partner...............................................................................48 Figure 14: Capital Structure at the 28th August.........................................................52 Figure 15: Capital Structure at the 3rd September 2005...........................................55 Figure 16: Debenhams: UK Department Store Sales (Source: Company data)...58 Figure 17: Debenhams: Designers at Debenhams Sales (Source: Company data) ...............................................................................................................................59 Figure 18: Debenhams: Bought versus Concessions Mix (Source: Company data) ...............................................................................................................................59 Figure 19: Debenhams 2006 Brand Mix (Source: Company data).........................60 Figure 20: Debenhams Brands Appeal versus the competition..............................60 Figure 21: Debenhams Supply Chain Improvements...............................................62 Figure 22: Debenhams use of sourcing from low cost countries..........................63 Figure 25: Designers at Debenhams.............................................................................64 Figure 23: Debenhams EBITDAR performance.......................................................69 Figure 24: Estimated ROCE analysis...........................................................................73 iii
  6. 6. LIST OF TABLES Number Page Table 1: Key Debenhams Facts.......................................................................................7 Table 2: Laragrove Offer: Transaction Sources and Uses (£m)..............................30 Table 3: Debenhams scheme of arrangement, expected timetable of principal events, 3rd November 2003.............................................................................42 Table 4: 2003 Acquisition: Transaction Sources and Uses (£m).............................45 Table 5: Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group......................................................................................................71 Table 6: Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group......................................................................................................71 iv
  7. 7. ACKNOWLEDGMENTS I would like to thank Professor Eli Talmor and Philippe Costeletos for their assistance in the preparation of this thesis. I found Eli’s course, Venture Finance and Private Equity, at the London Business School to be a fantastic grounding for this case study. Philippe, the partner who conducted the buyout for the Texas Pacific Group, provided useful information and a first hand insight into the case. In addition, I would like to thank my wife, Comfort and my children, Oliver and Violet for their patience and support during this undertaking. v
  8. 8. EXECUTIVE SUMMARY The three-year private equity investment by the Baroness Retail Consortium has returned CVC, Texas Pacific Group, and Merrill Lynch Private Equity a handsome profit. The deal, awarded European Buyout of the Year, is a two and a half year story of individual courage, opportunism, great timing, and good management. Ultimately, Baroness beat Laragrove to take Debenhams private, because they took a differential view about how to create additional value at Debenhams, and because they took a more optimistic view of the UK retail sector. By backing an experienced turnaround management team, Baroness was able to convince key stakeholders that they could create additional value. This, in combination with having a more optimistic view of the UK retail sector, allowed Baroness to justify paying a higher price for Debenhams. The bidding strategy and implementation by Baroness were innovative and impressive. The lead buyout partner, Philippe Costeletos, was new to his job at Texas Pacific and yet was able to convince key stakeholders to pursue a bid. Baroness managed to convince Debenhams to pay £1m per week to catch up with Laragrove’s due-diligence, and prevented others from bidding. The second winning bid by Baroness exposed divisions within Laragrove that, along with a shortened bid timeline allowed Baroness to win. The use of a scheme of arrangement saved money on taxes and more easily facilitated fund raising. Once in place, the new management team embarked on a new growth strategy. They created value by transforming Debenhams’ business model from a cost heavy ‘high-CAPEX, low-growth’ model to a more cost-efficient ‘high-growth, vi
  9. 9. low-CAPEX’ model by (1) improving operational effectiveness, (2) driving core sales and margin growth and transforming the supply chain, and (3) identifying new growth sources and areas for geographical expansion. The result was a 3.3x return on equity to investors at the IPO. An impressive 2.5x returns were achieved through operational improvements to the Debenhams business. These returns were 4.7x greater than if this transaction had been one hundred percent equity financed which would have only returned 0.7x1 the original equity. However, the impact of the British Land transaction on ROCE needs to be investigated further. Without an accurate measure of the capital employed in the business over the period of private ownership it is difficult to conclude that ROCE has increased during private ownership. The higher equity return enjoyed by Baroness did not come without additional risk. In addition to the structural problems of department stores competing with lower cost outlets and the cyclical risk of the UK retail market, there was considerable interest rate risk in this transaction. Baroness chose to mitigate business risks by conducting extensive due diligence and imposing a highly experienced management team to transform the business. Baroness mitigated interest rate risk through the use of hedging instruments. Baroness also mitigated its investment risk by choosing to invest equity in other businesses that are in other sectors and countries and by having a realistic exit strategy. 1 Company data and the following calculation: Return/(EV+Costs)=(2021-608)/(1868+40) vii
  10. 10. C h a p t e r I : T h e H i s t o r y o f D e b e n h a m s DEBENHAMS HISTORY2, ,3 4 Debenhams dates back as far as 1778. However, the name Debenhams did not appear until 1813 when Clark and William Debenhams began retail operations, in partnership, on Wigmore Street in central London. The Debenhams name was first used in 1813 when Thomas Clark and William Debenhams began retail operations as the Clark and Debenhams partnership on Wigmore Street in central London. The business grew to include a number of retail outlets across the UK and in 1905 Debenhams opened its first department store and became and incorporated company. In 1919, Debenhams acquired Harvey Nichols and, in 1928, Debenhams acquired Drapery Trust, to gain control of several regional retailers. Subsequently, Debenhams listed its shares on the London Stock Exchange and traded as an independent company. In 1958, Debenhams had a failed bid for Harrods and in 1972 Debenhams was unsuccessfully bid for by UDS. By 1985 Debenhams had a 2 Debenhams website 3 Debenhams plc IPO Offer Prospectus (Citigroup, 4th May 2006), p22 4 Debenhams plc (DataMonitor), p6 1
  11. 11. 2 portfolio of 65 department stores and owned a number of other companies, including Hamleys, Harvey Nichols and Lotus. In 1985 The Burton Group (now Arcadia) acquired Debenhams for £560m in a hostile bid. The following business were subsequently disposed of: Hamleys – 1985 to Harris Queensway Lotus and HM Rayne (shoe retailers) – 1986 and 1987 Wellbeck Fiancé (credit cards) – 1990 to GE Capital Harvey Nichols – 1991 to Dickson Concepts In addition to these disposals, the late 1980s and early 1990s Debenhams introduced exclusive ranges of own-bought merchandise in key product areas and significantly increased its portfolio of stores. By 1997, Debenhams introduced its first international franchise store in the Middle East. In January 1998, Debenhams was demerged from The Burton Group and was listed on the London Stock Exchange. Debenhams was an independent company once again. In 1999, Debenhams launched an eCommerce website and continued its international expansion with the launch of a store in Dubai. By December 2003, Debenhams had 104 stores in the UK and Ireland plus 10 franchises. Debenhams delisted from the London Stock Exchange in December 2003, following a trend set by its competitors BHS, Selfridges, and Arcadia. It was acquired by Baroness Retail Limited, a company owned indirectly by a group of funds managed or advised by CVC Capital Partners, Merrill Lynch Global Private Equity and Texas Pacific Group, other institutional investors and the
  12. 12. management team. Baroness trumped an offer from Permira, through the use of mezzanine financing, and paid £1.74bn in a leveraged buyout. Since the 2003 acquisition the group has undergone a number of refinancing rounds. In May 2005, the group underwent a major refinancing and restructuring in which the company became the parent of the group. In May 2006, Debenhams was IPO’ed . DEBENHAMS TODAY5,6 Debenhams is a leading multi-category retailer and the second biggest department store chain in the UK with approximately 18.6% of total in the United Kingdom department store sales, having increased its market share from 15.3% in 2003. 11.8 12.9 12.3 12.1 12.1 12.8 13.4 13.8 13.7 13.3 12.2% 13.0%13.0%13.8%14.7% 18.6% 15.2%16.4% 12.0% 14.8% 11 11 12 12 13 13 14 14 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E 0% 5% 10% 15% 20% Market Value (£Bn) Debenhams Market Share Figure 2: Debenhams: UK Department Store Sales (Source: Company data) 5 Debenhams website 6 Debenhams plc IPO Offer Prospectus (Citigroup, 4th May 2006), p22 3
  13. 13. Debenhams has a strong presence in every key product category, including women, men, childrenswear, cosmetics, and household goods. Along with its range of women’s, men’s and childrenswear, Debenhams also offers a personal shopping service, a wedding service, in-store catering, Debenhams Direct (home shopping catalogue), financial services, and a fully transactional website. Womenswear 28.4% Menswear 17.4% Childrenswear 5.3% Home & Gift 16.9% Health & Beauty 13.6% Accessories 10.2% Food Services 2.8% Lingerie 5.4% Figure 3: Debenhams: FY 2005 Sales Mix (Source: Company data) Debenhams sells a number of international and designer brands, as well as its own brands, including Designers at Debenhams. Sales from Designers at Debenhams ranges’ sales have increased substantially in recent years. 2 4 8 13 83 143 208 266 324 450 0 100 200 300 400 500 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 Target Value (£M) Figure 4: Debenhams: Designers at Debenhams Sales (Source: Company data) 4
  14. 14. Debenhams has a successful own brand portfolio of approximately 55 own brands (such as Debut, Maine New England, Red Herring and Thomas Nash) including 25 Designers at Debenhams brands. The Designers at Debenhams range offers customers exclusive product lines at mainstream prices by designers such as Jasper Conran, Julien Macdonald, John Rocha and Matthew Williamson. Third party brands are either bought by Debenhams (such as Estée Lauder and Levi Strauss) or available through in-store concessions (such as Oasis). 75 76 76 74 72 70 75 25 24 24 26 28 30 25 2000 2001 2002 2003 2004 2005 Target Own Bought Concessions Figure 5: Debenhams: Own bought versus Concessions Mix (Source: Company data) Debenhams has 123 stores, including three Desire by Debenhams stores, across the UK and Ireland, with approximately 9.3 million square feet of trading space and around 20,000 employees. The stores are located in various locations, including town centres, high streets and shopping centers and cover a wide geographic and size range. 5
  15. 15. In addition, Debenhams has successfully expanded into international markets by partnering with a small number of dedicated, regional franchise partners. Debenhams currently has 29 international franchise stores in 15 countries outside the UK and Ireland, with a further 15 franchises scheduled to open by the end of the 2008 financial year. Debenhams is able to offer a unique value proposition to its international clients through the use of the Debenhams brand, its portfolio of over 100 successful designer and own brands, and Debenhams ability to adapt their stores to local consumer preferences or cultural requirements. Currently, Debenhams operates franchise stores in Bahrain, Czech Republic, Cyprus, Denmark, Hungary - Budapest, Iceland - Reykjavic, Indonesia, Kuwait Qatar - Doha, Saudi Arabia – Jeddah and Riyadh, Malaysia, Philippines, Sweden - Stockholm, UAE - Dubai and Sharjah, and Turkey. 6
  16. 16. KEY FACTS Head Office Debenhams Retail plc 1 Welbeck Street London W1G 0AA Phone 084 4561 6161 Fax 020 7408 3366 Web Address www.debenhams.com Gross Transaction Value (£M) £1810.2m (GAAP 2003) £2,224.7m (IFRS 2006E) EBITDA (£M) £218.1m (GAAP 2003) £331.7m (IFRS 2006E) % of GTV 12.0% (GAAP 2003) 14.9% (IFRS 2006E) Financial Year End August Employees 21,194 (August 2003) 20,262 (March 2006) SIC Codes SIC 5311 Department Stores NAICS Code 45211 Company Registration Number: 83395 VAT Registration Number: 698 7979 22 Table 1: Key Debenhams Facts 7
  17. 17. C h a p t e r I I : T h e P r i v a t e E q u i t y F i r m s LARAGROVE7 Laragrove was a private equity consortium led by Permira that consisted of Permira, Blackstone, Goldman Sachs PLA, and the Directors of Debenhams. Permira At the time of the transaction, Permira was one of Europe’s leading private equity firms advising funds of nearly €9 billion. Permira was an independent business with offices in London, Frankfurt, Milan, Paris, Stockholm, and New York and focused on European buy-out transactions. Since 1985, funds advised by Permira had invested in more than 250 transactions. The Blackstone Group The Blackstone Group is a private investment firm that was founded in 1985. At the time of the transaction, The Blackstone Group, had offices in New York and London and had raised over $14 billion for private equity investment. It had approximately $6.5 billion in committed capital through its primary investment vehicle, Blackstone Capital Partners IV. In addition to private equity, The Blackstone Group also consists of private retail investing, corporate debt investing, marketable alternative asset management, mergers and acquisitions advisory, and restructuring and reorganisation advisory. 7 Recommended Cash Offer by Laragrove Limited for Debenhams (UBS Investment Bank, 04/08/2003), p10-11 8
  18. 18. Goldman Sachs PLA Goldman Sachs is a leading global investment banking, securities and investment management firm that provides a wide range of services worldwide to a substantial and diversified client base. This client base includes corporations, financial institutions, governments and high net worth individuals. Founded in 1869, Goldman Sachs is one of the oldest and largest investment banking firms. The firm is headquartered in New York and maintains offices in London, Frankfurt, Tokyo, Hong Kong, and other major financial centres. At the time of the acquisition, Goldman Sachs Capital Partners and investment partnerships affiliated with Goldman Sachs had committed capital of approximately $5.25 billion. GSCP 2000 was the primary investment vehicle of Goldman Sachs for long term investments in equity, equity related securities in privately negotiated transactions, leveraged buyouts and acquisitions. Goldman Sachs and its partners had made global and diversified investments of approximately £11 billion in around five hundred companies since 1986. Notable investments included Yankees Entertainment and Sports Network, LLC and R.H. Donnelley Corporation. Major European investments included Cognis, Messer Griesheim, Legrand, and the cable television operations of Deutsche Telekom. BARONESS RETAIL CONSORTIUM8 Baroness Retail Consortium was a private equity consortium led by CVC that consisted of CVC, Texas Pacific Group, Merrill Lynch Global Private Equity, and the Independent Directors of Debenhams. 8 Recommended Cash Acquisition by Baroness Retail Limited for Debenhams by means of a Scheme of Arrangement (Baroness Retail Limited, 12/09/2003), p12-13 9
  19. 19. CVC At the time of the acquisitions, CVC Capital Partners was a leading independent pan European private equity group with a strong, local European network of 11 offices focused on medium to large management buy-outs. Since 1993, CVC Capital Partners had raised over US$8 billion that was to be invested in European buy-outs. CVC Capital Partners’ current portfolio included 65 companies with a combined turnover of €33 billion, which operated in 25 countries and employed over 200,000 people. Texas Pacific Group (TPG) David Bonderman, James G. Coulter and William S. Price, III founded the TPG GROUP in 1993 to pursue public and private investment opportunities through a variety of methods, including leveraged buyouts, recapitalisations, joint ventures and strategic public securities investments. TPG Partners III, L.P., (together with certain parallel investment entities) is a US$4 billion private equity fund formed in 1999 to make investments in corporate acquisitions, and will be the principal TPG Fund investing in Debenhams. The TPG Funds and their predecessor funds currently manage over US$8 billion of committed capital. Over the past decade, the TPG Funds, their predecessor funds and their principals have invested over US$6 billion of equity capital in over 50 transactions. Merrill Lynch Global Private Equity (MLGPE) Merrill Lynch is one of the world’s leading financial management and advisory companies, with offices in 36 countries and total client assets of approximately US$1.4 trillion. As an investment bank, it is a leading global underwriter of debt and equity securities and strategic advisor to corporations, governments, institutions and individuals worldwide. Through Merrill Lynch Investment Managers, the company is one of the world’s largest managers of financial assets. MLGPE is the private equity arm of Merrill Lynch, and manages the MLGPE 10
  20. 20. Vehicles. The MLGPE Vehicles carry out long-term equity and equity-linked investments in securities in private transactions, buyouts, and acquisitions. 11
  21. 21. C h a p t e r I I I : T h e L e v e r a g e d B u y o u t M o d e l The Debenhams acquisition by Baroness Retail Consortium is a classic example of a leveraged buyout. At the time of the leveraged buyout a small group of investors purchased all of the equity of Debenhams. Baroness Retail Consortium finances this acquisition with debt that was secured against Debenhams’ assets. After the leveraged buyout the debt was restructured and assets were acquired and divested. Debt restructuring allowed Debenhams to achieve lower rates of interest on their debt and enabled Debenhams to achieve a greater distance of their debt from their assets. This reduced interest costs and prepared Debenhams for an eventual IPO. Real estate assets were divested to British Land to reduce expensive borrowing, allow the business to focus on core activities, and to reduce the amount of capital employed in the business. New store locations were acquired to enable expansion of the business. Over the course of Baroness Retails investment in Debenhams, cash was swept out of the business to pay down the debt used to acquire Debenhams. These activities increased the enterprise value of Debenhams and the percentage of equity in the investment. I believe that Baronesses most likely exit was always going to be an IPO on the London Stock Exchange. However, the consortium could have chosen to conduct a new leveraged buyout of Debenhams or to have exited the investment through a trade sale to another retail company. THE EFFECT OF LEVERAGE ON AN INVESTMENT Most young house buyers in the UK would surely appreciate the effect of leverage on an investment. Low interest rates and an increasingly sophisticated financial market for debt have allowed young house buyers to borrow increasing 12
  22. 22. 13 multiples of their incomes to purchase property. These factors along with demographic factors (increased immigration and more single households) have boosted the demand for housing whilst tight planning regulations and a lack of investment in travel infrastructure has restricted the supply of housing. The corporate world has seen a similar phenomenon. Historically low interest rates and an increasingly sophisticated financial market have allowed acquirers to leverage their transactions at much higher levels and with lower cost debt. This has caused a resurgence in the popularity of leveraged buyouts. How does leverage increase the return to equity? Let us consider two examples: Example One: One hundred percent of equity ULeveraged Buyout (year 0)U EBITDA: 5 EV/EBITDA multiple: 10x E = 50 UExit (year 3)U EBITDA: 7.5 EV/EBITDA multiple: 12x E = 90 Cash multiple: 90/50 = 1.8x IRR = 1.8P 1/3 P –1 = 22% 50 90 0 20 40 60 80 100 LBO Exit Equity 1.8x
  23. 23. 14 Example Two: Thirty percent of equity ULeveraged Buyout (year 0)U EV = 50 D = 35 E = 15 UExit (year 3)U EV = 90 D = 20 E = 70 Cash multiple: 70/15 = 4.7x IRR = 4.7P 1/3 P –1 = 68% 15 70 35 20 0 20 40 60 80 100 LBO Exit Equity Debt Clearly, a leveraged buyout has a higher internal rate of return than a pure equity investment. However, this is misleading. If the enterprise value of the company was reduced substantially the leveraged buyout financing could potentially have their equity investment wiped out. In comparison, a one hundred percent equity investment would not suffer as large a loss. Let us examine two further examples where the value of the firm halves. Example Three: One hundred percent of equity ULeveraged Buyout (year 0)U EBITDA: 5 EV/EBITDA multiple: 10x E = 50 UExit (year 3)U EBITDA: 7.5 EV/EBITDA multiple: 12x E = 25 Cash multiple: 25/50 = 1/2x IRR = 0.5P 1/3 P –1 = (21)% 50 25 0 20 40 60 LBO Exit Equity 1/2x 4.7x
  24. 24. 15 Example Four: Thirty percent of equity ULeveraged Buyout (year 0)U EV = 50 D = 35 E = 15 UExit (year 3)U EV = 25 D = 20 E = 5 Cash multiple: 5/15 = 1/3x IRR = (1/3)P 1/3 P –1 = (31)% 15 5 35 20 0 20 40 60 LBO Exit Equity Debt In the examples above the reduction in the equity value of the company was more heavily felt by equity investors in the leveraged transaction. Indeed, the higher potential return (and risk of loss) of a leveraged buyout is reflected in a higher market cost of equity that is expected for a leveraged transaction. Profits from leveraged buyouts have fuelled interest in Private Equity, a previously much ignored form of ownership. This has increased the multiples at which acquirers are now required to pay to acquire targets. Indeed in many industries, trade buyers who were thought to have been able to bid more for companies through achieving synergies with their existing business(es) are being outbid by purely financial buyers. Financial buyers traditionally were able to pay more because low interest rates have allowed these investors to achieve higher financial returns through increased leverage than trade buyers can achieve through creating value through releasing synergies. As mainly public companies, trade buyers have not been able to match this degree of leverage due to pension and other responsibilities of public ownership. 1/3x
  25. 25. 16 SOURCES OF VALUE CREATION IN A LEVERAGED BUYOUT A leveraged buyout can earn a return to equity in one of three ways. UValue creationU ( V∆ ) occurs by improving the operating, investment, and / or capital efficiency of the company. UValue arbitrageU ( P∆ ) exploits mispricing and is essentially a transfer of value from the existing shareholders to new shareholders. Value transfer ( O∆ ) transfers value from other stakeholders to the shareholders. These three sources of value creation will be examined in turn. Value Creation ( V∆ ) Value is created by improving the operating, investment, and capital efficiency of the company. Many people use EBITDA and EBITDA/ Sales to gauge value creation. This has the advantage of being a number that is ‘close to cash’ that can be used with a multiple to see the impact on the value of the company. How this measure neglects to include capital that is employed in the business. Additional capital can destroy value but increase EBITDA and EBITDA. A ROCE analysis provides an alternative viewpoint that can be used in conjunction with EBITDA and EBITDA/Sales growth. The diagram below shows a ROCE analysis of a fictional company, Flexible Connections. The x-axis (Sales/CE) is a measure of capital efficiency. The y-axis (NOPAT/Sales) is a measure of operating or profitability of the company. Together they show the ROCE of the company, the curved lines of constant value. By increasing ROCE, shareholder value should be increased. So, any additional investment (the addition of capital employed in the business) needs to generate sufficiently profitable sales in order to maintain or enhance ROCE and therefore shareholder value.
  26. 26. 17 Sources: Flexible Connections Case & My Analysis FLEXIBLE CONNECTIONS LIMITED ROCE ANALYSIS 2004 2005 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 0.000 0.500 1.000 1.500 2.000 NOPAT / Sales Sales / CE = £20M Revenue 13.3% ROCE is attractive, however NOPAT/Sales declined from 9.7% in 2004 to 8.6% in 2005. This was despite FCL focusing on the more profitable ‘Direct Order’ segment. ROCE (%) 20 10 13.3% 14.8% 12 14 16 18 8 6 4 2 Figure 6: ROCE Analysis of a fictional company; Flexible Connections Sources of value creation include portfolio company, product, and asset adjustments that enhance profitability and / or capital efficiency and efficiency gains through cutting unnecessary costs, better control of inventories and accounts receivables. Value Arbitrage ( P∆ ) The ‘buy low’ and ‘sell high’ view of leveraged buyouts seek to source deal that exploit mispricing in equity markets. Firms may take a contrarian view about the market and / or buy in an industry down cycle. A private equity firms longer investment horizon allows them to be able to ride the cycle to its peak before exiting at a profit.
  27. 27. 18 Value Transfer ( O∆ ) Tax Savings: very high leverage generates substantial tax savings for a leveraged company. Indeed, many companies do not pay any taxes during their period of high leverage. Due to the increasingly competitive nature of the bidding process for leveraged buyout transactions these gains are being priced into the premium paid to conduct the leveraged buyout. Transfers from new creditors: new creditors may overvalue the leveraged buyouts financial claims. During the 1990’s the junk bond overheated and creditors lost out. Many people have similar concerns over the current market. Risk shifting to existing creditors and preferred stock holders: existing covenants may not sufficiently protect existing creditors. This depends on the covenants that have been agreed between the creditor and the company. Employees: the new owners may be tougher in pay negotiations because of the need to finance their increased debt load. What makes a good deal for shareholders? A good deal for acquiring shareholders requires that: CPOV +∆+∆>∆ So, the value created in the transaction must be greater than the value transferred to other stakeholders, the premium paid to the old shareholders, and the costs of the transaction. What makes a good leveraged buyout candidate? A good leveraged buyout candidate has the ability to sustain a huge debt load and has the potential for efficiency gains.
  28. 28. To sustain a large debt load high and stable cash flows are required. Examples are found in market leading companies that are in mature and recession proof industries and who do not require large amounts of capital expenditure. Larger amounts of debt can be achieved at lower rates if this company has a relatively liquid balance sheet (collaterisable assets and excess cash/liquid investments), separable non-core assets and a low current leverage. Efficiency gains can be achieved by running the company more efficiently to achieve cost reductions and / or top-line sales growth that improve profitability. For example, a store refurbishment program that uses less capital but that achieves the same results would be an example. So would reducing the value of inventory whilst obtaining the same gross margins and sales. This is a very large area that will be examined in more detail later in this paper for the Debenhams transaction. What are the key risks of a leveraged buyout and what remedial action can be taken to address these risks? Interest rates could rise: The western world currently enjoys historically low interest rates. This combination of a low interest rate environment and more sophisticated, liquid, and more relaxed lending policies by banks have, I believe, been instrumental in causing asset prices to rise across the economy. Leveraged buyouts should automatically do well in a low interest rate environment with rising asset prices. Many people in the private equity and financial markets fear the impending reversal of this trend. A rising interest rate environment would cause a fall in asset prices and an increase in variable interest rates. Leveraged buyout firms can and have protested themselves from these risks by taking out fixed rate debt and / or by using hedging instruments to protect cash flows from rising interest rates. 19
  29. 29. The private equity company might overpay due to adverse information asymmetry: Information asymmetry between the buyer, the private equity company, and the vendor: UK takeover regulations require all company information to be shared with a potential buyer. Sufficient due-diligence enables this gap to be reduced. Indeed, the private equity buyer may indeed have an informational advantage because they seek to obtain a differential and more valuable view of the company that allows the private equity company to pay more for a winning bid. The firm might not be able to afford it’s interest payments: Reduction in the firms cash flows: Appropriate investment selection allows the selection of investments that have robust cash flows during a downturn and a portfolio of investments allows a fund to spread non-systemic risk between investments. 20
  30. 30. C h a p t e r I V : T h e T r a n s a c t i o n T i m e l i n e 9, ,10 11 The events of this deal can be broken down into two periods: (1) How Baroness won the bid and (2) Baronesses investment in Debenhams. The remainder of this chapter will present the key events during these two periods before discussing further the events in these two time periods in the next two chapters. HOW BARONESS WON THE BID 1998 Debenhams completes their London IPO and demerges from the Burton Group May 12th 2003 Debenhams receives a proposal from Permira to acquire all of the share capital of Debenhams. A committee of Independent Directors is appointed to consider the proposal by the management team and Permira. May 19th 2003 Philippe Costeletos starts his new job with responsibility for retail at the Texas Pacific Group. June 5th 2003 CVC and Texas Pacific Group meet their proposed new management team. 9 Debenhams plc IPO Offer Prospectus (Citigroup, 4th May 2006) 10 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 11 Recommended Cash Offer by Laragrove Limited for Debenhams (UBS Investment Bank, 04/08/2003) 21
  31. 31. Mid June 2003 CVC and Texas Pacific Group partner, together with Merrill Lynch Private Equity and the new management team to form Baroness Retail. June 29th 2003 Debenhams reveals that it has had an approach from Baroness and agrees to pay Baroness £1m a week for 6 weeks diligence. July - August 2003 Baroness conducts team diligence and site visits at Debenhams. July 23rd 2003 The board of Laragrove (a consortium led by Permira, Blackstone, and Goldman Sachs PIA) announce that they had agreed the terms of a recommended cash offer of £4.25 per share for Debenhams. This values Debenhams at ~£1.5bn and was recommended to shareholders. August - September 2003 Baroness runs a dual track financing process. August 4th 2003 The Laragrove offer was made to Debenhams shareholders. September 5th 2003 The Baroness team change their financing to a senior and high yield structure. These documents are produced over one weekend. September 12th 2003 Baroness Retail Consortium, consisting of CVC, Texas Pacific Group, and Merrill Lynch Private Equity, and the Independent Directors announced a £4.55 per 22
  32. 32. share cash offer for Debenhams to be completed under a scheme of arrangement. On the same day Laragrove stated that it was considering its position. Debenhams stock trades at above £4.55 for the next month. September 29th 2003 Baroness Retail Ltd. publishes a scheme of arrangement for the proposed acquisition of Debenhams. October 23rd 2003 Baroness Retail increased its cash offer to £4.70 per share. October 24th 2003 Laragrove confirmed that it would not be increasing its offer or participate in a bidding process that was scheduled to start on October 31st 2003. November 1st 2003 Baroness Retail Ltd. publishes a revised scheme of arrangement for the proposed acquisition of Debenhams. November 5th 2003 European Commission grants unconditional clearance under the EC Merger Regulation for Baroness Retails proposed acquisition of Debenhams. December 5th 2003 Debenhams shares are de-listed from the London Stock Exchange. 23
  33. 33. BARONESSES INVESTMENT IN DEBENHAMS December 4th 2003: The Acquisition of Debenhams by Baroness Baroness Retail Consortium acquire Debenhams in a £1.9bn public to private transaction. The deal is financed by £608m equity, £335m Property Bridge financing, and £956m term debt. April 23rd 2004: Refinance of bridge with a mortgage facility £375m mortgage facility was raised to refinance the more expensive property bridge financing. 2004: Refinance of Mezzanine Facility with a High Yield Bond The original acquisition mezzanine facility of £325m is refinanced with a high yield bond of a similar amount. February 22nd 2005: The British Land Sale-and-Leaseback Transaction Debenhams completes a sale-and-lease-back with British Land of 23 freehold and long leasehold Debenhams stores. Debenhams receives a £490m consideration from British Land. May 16th 2005: The 2005 Acquisition The capital structure of Baroness is changed to deliver a £1.3Bn dividend to investors. This dividend was funded by cash generation within Debenhams, proceeds from the sale and leaseback of properties and through the refinancing of acquisition debt. May 26th to June 23rd 2005: Senior Credit Agreement Debenhams completes £2.05bn refinancing with Credit Suisse, Merrill Lynch, Morgan Stanley and Citigroup. 24
  34. 34. 19th April 2006 Debenhams completes a ‘New Credit Agreement’ with The Royal Bank of Scotland, The Governor and Company of the Bank of Scotland, Lloyds TSB Bank, and Barclays Capital. April 2006 Debenhams announces its £1.74bn flotation 5th May 2006 Debenhams returns to the London Stock Exchange 25
  35. 35. Figure 7: Reaching New Heights 26
  36. 36. C h a p t e r V : H o w B a r o n e s s W o n t h e B i d PERMIRA’S FAILED BID The retail sector in 2003 was expected to perform badly 2003. The Debenhams LBO, at the price ultimately paid by Debenhams, went against market sentiment at the time and was a gutsy move by the leader of the buyout Philippe Costeletos. Philippe joined the Texas Pacific Group on the 19th May 2003 to head up the retail practice and organized the Baroness Retail Consortium bid. This bid included a number of innovative features and took a different and more valuable view of Debenhams and the sector than that of Permira. The Permira Offer In mid-May 2003, Debenhams received a cash offer of 425p per share from private equity firm Permira Ltd.12 Permira was given until the end of June to complete due diligence and finalise funding arrangements. New bidders were prevented from launching a bid because (1) Permira was months ahead in their due diligence, (2) the existing management team supported the Permira bid, (3) there was a breakup fee that would compensate Permira should another higher winning bid arise (4) The bid arguably represented a fair price with the existing management in place and reflected the prevailing financial market sentiment of the sector. 12 Mintel, Department and Variety Store Retailing – UK (Retail Intelligence, June 2003), p85 27
  37. 37. Funds advised by Permira (37.5%) Funds advised by Balckstone (20.8%) Funds advised by GSCP (20.8%) Co-Investors (10.9%) Baron LP Baron Guernsey 3 Ltd (C&D shares) Laraway Debenhams Ltd. Other Subsidiaries Debenhams Card Handling Services Debenhams Gift Vouchers Ltd. Debenhams Property Ltd. Debenhams Retail plc Senior Facility Management (10%) Laraplace Wheehurst Laragrove Baron Guernsey 2 Ltd (B shares) Secured Bridge Facility Mezzanine Facility Deep Discounted Bonds Baron Guernsey 1 Ltd (A shares) Equity of £528,404,647 Funds advised by Permira (37.5%) Funds advised by Balckstone (20.8%) Funds advised by GSCP (20.8%) Co-Investors (10.9%) Baron LP Baron Guernsey 3 Ltd (C&D shares) Laraway Debenhams Ltd. Other Subsidiaries Debenhams Card Handling Services Debenhams Gift Vouchers Ltd. Debenhams Property Ltd. Debenhams Retail plc Senior Facility Management (10%) Laraplace Wheehurst Laragrove Baron Guernsey 2 Ltd (B shares) Secured Bridge Facility Mezzanine Facility Deep Discounted Bonds Baron Guernsey 1 Ltd (A shares) Equity of £528,404,647 Figure 8: Laragrove Offers Capital Structure 28
  38. 38. The Financing of Laragrove’s Bid For Debenhams The capital structure of the holding companies that formed the Laragrove bidding consortium was organized in a tax efficient manner. The proposed capital structure of the transaction is shown in Figure 8: Laragrove Offers Capital Structure. This capital structure was used to enable Laragrove Consortium members to be able to recoup money from the transaction in a tax efficient way. The consortium provided an equity injection of £528,404,647 in a limited partnership Baron LP. This limited partnership owned four classes of shares in three limited companies in Guernsey. The equity investment was protected from possible dilution in further rounds of investment by using deep discounted bonds that were held by another company owned by the Guernsey limited companies, Laraway. Laraway owned Laraplace, Whelhurst, and the bidding vehicle, Laragrove. Debt used to finance the transaction along with the proceeds from the aforementioned equity injection would have been used to buy Debenhams. The debt used to finance the transaction, unlike the deep discounted bonds, were placed close to the assets Debenhams and its collaterisable property. Three types of debt were used. A senior facility of variable rates at different premiums to LIBOR and of varying terms constituted the bulk of the money that would be used to finance the transaction. This facility also included a multi-currency revolver to enable efficient running of the business. A bridge facility secured against the freehold and long leasehold properties of Debenhams provided a cheaper source of interim finance. Finally, there was a high yield component on a short-term basis that provided that remainder of the finance. 29
  39. 39. Transaction Sources and Uses Laragrove committed £528 million of equity to the purchase of Debenhams. The transaction had an enterprise value of £1669 million with additional costs of £55 million incurred. This represented a leverage ratio of 68%. Sources Uses Term loan - A 280 Purchased equity1 1541 Term loan - B 120 Debt refinanced2 128 Term loan - C 120 Other3 55 Deep discount bonds 506 Bridge facility 325 Mezzanine facility 350 Ordinary equity 22 Total 1723 1723 Table 2: Laragrove Offer: Transaction Sources and Uses (£m) Notes 1. Baroness Retail Consortium paid £4.25 per share. The offer document, 4th August 2003, used 362,543,038 issued shares to calculate the Laragrove offer. This represents a purchased equity value of £1.541bn. 2. On the 30th August 2003, Debenhams had £127.8m of net debt outstanding. This figure represents an estimate of the net debt outstanding at the time of the transaction. 3. The remainder is expected to consist primarily of transaction fees relating to the transaction and variation in the amount of the net debt outstanding. 30
  40. 40. Immediate Refinancing Post Acquisition The Laragrove offer document contained agreements to setup a mortgage facility for £160 million secured on Debenhams stores and sale and leaseback agreements to Legal and General of £144 million, to Ravenscroft £22.4 million, and RBS (if no other offer was received) of £145 million. Together these transactions amounted to £471.4 million. Interest Rate Risk Mitigation Plan Hedging contracts were entered into that would protect two thirds of the interest costs of the debt used to finance the acquisition. It was the intention of Permira to refinance most (if not all) of the acquisition debt within a short timeframe after the acquisition. So variable rate debt and hedging contracts were used to mitigate exchange rate risk rather than the use of fixed interest rate debt. BARONESS ENTERS THE RACE Shareholder objections and the entry of Baroness Permira’s offer at this stage looked like it was a done deal. However, there were objections from Debenhams shareholders about the price that Permira was going to pay. Some shareholders regarded the lack of a competitive process and the fact that private equity companies had had a recent history of making large amounts of money from the retail sector as sufficient reasons to correctly conclude that Permira was going to buy Debenhams at too low a price. “Before we entered the process, there was little incentive for Permira to revise is price, even though some institutional shareholders were expressing concerns”13 13 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 31
  41. 41. Philippe Costeletos starts his new job at the Texas Pacific Group Philippe Costeletos started his new job at the Texas Pacific Group on the 19th May 2003. He had responsibility for leading the retail industry sector at the Texas Pacific Group in their London office. Philippe seized the opportunity to put together a competing bid for Debenhams. He had a differential view of both the company and sector in mind that would allow him to create additional value in a take-private of Debenhams. Crucially, he also had in mind a plan to catch up on the months of due-diligence that Permira had already completed. Ultimately, Philippe Costeletos would be the lead partner for the transaction and would earn himself and his company European Buyout of the year for this transaction. Baroness Persuades Debenhams to Pay for Due-diligence Philippe’s decision to ask for due diligence to be paid was a crucial one. He was new in his job at the Texas Pacific Group and had to establish the credibility to persuade his investment committee that his differential view was worth exploring and Debenhams that this was worth paying for. “… Given how far ahead the competitors were in the process, we couldn’t justify going out of pocket with the diligence costs, so we asked to be compensated for it. This wasn’t something that had been done before, but we felt it was the only way to move forward. As a result, the advisors were able to add some competitive tension to the sales process and ultimately a much higher price for shareholders.”14 Philippe’s ability to persuade his investment committee that he would be able to catch up due diligence work was aided by UK competition law which, as long as his team asked for same questions as the Permira team, meant that he would receive the same information as Permira. Nonetheless to persuade the investment 14 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 32
  42. 42. committee that this could be done was brilliant and only matched by his ability to deliver on his promise to catch up with Permira. In order to add competitive tension to the bidding process, Debenhams agreed to pay £1.06m per week to Baroness to conduct due-diligence on Philippe’s differential view of Debenhams future potential and prospects. Details of this inducement fee15 are contained in the Laragrove offer prospectus. The inducement fee of £8.5m would compensate Laragrove and Baroness should a higher bid be accepted. This feature also provided up to £6m for CVC and TPG to conduct due diligence on Debenhams over a period of five weeks. This fee, limited to 1% of any offer for Debenhams, also provided an additional disincentive of up to £23m for any other bidder to enter the bidding race for Debenhams. BARONESSES DIFFERENTIAL AND MORE VALUABLE VIEW OF THE BUSINESS Baroness ultimately had a differential view to Permira that resulted in a higher valuation and bid for Debenhams. This differential view was based on a more optimistic view than the market of the UK retail sector and that the Debenhams business could be more effectively managed under a new set of managers. This differential view was crucial to Philippe and Baroness pursuing a bid for Debenhams: “We were working on a different plan [than Permira]. If we didn’t have our own strong management team and investment thesis, we wouldn’t have bid.” 15 Recommended Cash Offer by Laragrove Limited for Debenhams (UBS Investment Bank, 04/08/2003), p12 33
  43. 43. A Different View of the Sector A financials markets at the time had concluded correctly that at best that the department store retail market in the UK was flat. The large-mixed goods retail sector, although the fastest growing segment, was only growing at a compounded annual growth rate of 3.7% between 2000 and 200316 . Analysts were worried that consumer spending was going to hit the wall in the UK. Baroness took a different view by looking to the USA, which was ahead of the UK in the economic cycle. From this they concluded that the UK consumer would get used to living with higher levels of debt. At worst a slow down was predicted but not a sudden fall in consumer expenditure and therefore in the prospects of Debenhams. Indeed, Debenhams had a better track record and stronger growth prospects than its competitors. 100 103 109 116 121 123 127 100 110 120 130 1998 1999 2000 2001 2002 2003 2004 All Retail Sales Mixed Goods Retailers Large Mixed Small Mixed Figure 9: Relative Performance of UK Mixed Goods Retailers by Size (UK Office of National Statistics) A Better Management Team Baroness also believed that they had a management team that would be better than the incumbent managers at Debenhams. The senior management team that 16 Office of National Statistics 34
  44. 44. Baroness proposed is shown in Figure 12: Baroness Bids Senior Management Team below. Rob Templeman, Michael Sharp, and John Lovering - who turned around Homebase and Halfords were employed to turn around Debenhams. John Lovering, assumed the part time role of Chairman of Debenhams in addition to his duties as a Director of Baroness Retail. Ordinarily one would question the validity of this argument as the existing management were skilled, experienced, and knowledgeable about the Debenhams business. This should have given the Laragrove bid an edge. John Lovering Chairman Rob Templeman CEO Chris Woodhouse FD Michael Sharp COO Nigel Palmer Retail Ops Dir. Nikki Zamblera HR Director Figure 10: Baroness Bids Senior Management Team However, the three senior members of the executive management team that were brought onboard were very strong indeed. They had over seventy years of retail experience between them at the time of the 2003 Acquisition (see Appendix G: Directors Details). Both Rob Templeman (CEO) and Chris Woodhouse (CFO) had worked together during the turnarounds of Homebase and Halfords. They both have a reputation for being able to grasp the details of the business, resulting in a deeper understanding of the business. Michael Sharp (COO) was the effective number two to CEO Terry Green when Debenhams demerged from Burton in early 1998. At the Burton Group, Michael was regarded as one of 35
  45. 45. the strongest operators in the Burton Group. He is also the former Managing Director of Principles. Ultimately this gave the Baroness team the experience, credibility, and fresh perspective that allowed them to demonstrate additional value from their management team vis-à-vis the incumbent management team backed by Permira. Indeed, the lead buyout partner from the Texas Pacific Group stated that “For us to really gain conviction in this deal, we just referred back to the [management’s] track record of success”17 THE FIRST BARONESS BID FOR DEBENHAMS Debenhams decision to invest in due-diligence by Baroness was validated and rewarded with a £4.55 conventional cash offer. This cash offer was made with the option for Debenhams to convert this bid to a scheme of arrangement. Ultimately, Debenhams exercised the option to use a scheme of arrangement. Capital Structure of the Debenhams Transaction The capital structure of the holding companies that formed the Baroness bidding consortium was organized in a tax efficient manner. The proposed capital structure of the transaction is shown in Figure 12: Baroness Capital Structure for the 455p bid. This capital structure was used to enable Baroness Consortium members to be able to recoup money from the transaction in a tax efficient way. The consortium provided an equity injection of £599,000,000 in a limited partnership Baroness Group LP. This limited partnership owned Baroness Group Holdings. The 17 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 36
  46. 46. equity investment was protected from possible dilution in further rounds of investment by using deep discounted bonds (called the senior credit facility) that were held by Baroness Group Holdings. Baroness Holdings UK is a wholly owned subsidiary of Baroness Group Holdings and owns a number of intermediate companies. These intermediate companies own Baroness Retail Ltd., the bidding vehicle for the transaction. Debt used to finance the transaction along with the proceeds from the aforementioned equity injection would be used to buy Debenhams. As with the Laragrove bid, the original financing package included a senior facility with a mezzanine bridge funded by a high-yield bond. The bank consortium consisted of Credit Suisse, Merrill Lynch, Morgan Stanley, and Citigroup. The debt used to finance the transaction, unlike the deep discounted bonds, were placed close to the assets Debenhams and its collaterisable property. Three types of debt were used. A senior facility of variable rates at different premiums to LIBOR and of varying terms constituted the bulk of the money that would be used to finance the transaction. This facility also included a multi-currency revolver to enable efficient running of the business. A bridge facility secured against the freehold and long leasehold properties of Debenhams provided a cheaper source of interim finance. Finally, there was a high yield component on a short-term basis that provided the remainder of the finance. Most of the debt was raised as a high yield debt because “The high-yield market was more liquid than the market for mezzanine debt. It had a deeper investor pool, meaning you could raise more.” [Brian Gray, Freshfields Partner18 ] 18 Cushnie, L. “Debenhams’ return to the LSE ensures saga ends well for all” The Lawyer, Vol. 20 Issue 18 (8th May, 2006), 13-13 37
  47. 47. Funds advised by TPG (37.9%) Funds advised by CVC (37.9%) Funds advised by MLGPE (15.4%) Management (8.8%) Baroness Group LP Baroness Group Holdings BF VI Baroness Retail Ltd. Debenhams Ltd. Senior Credit Facility Term £566m Revolver £125m Baroness Holdings UK BF I BF II BF IV BF III BF V Mezzanine Facility £300m Bridge Facility £354.7m Deep Discounted Bonds A = £289.4m B = £165.8m C = £165.8m Total = 621m Equity of £599,000,000 Funds advised by TPG (37.9%) Funds advised by CVC (37.9%) Funds advised by MLGPE (15.4%) Management (8.8%) Baroness Group LP Baroness Group Holdings BF VI Baroness Retail Ltd. Debenhams Ltd. Senior Credit Facility Term £566m Revolver £125m Baroness Holdings UK BF I BF II BF IV BF III BF V Mezzanine Facility £300m Bridge Facility £354.7m Deep Discounted Bonds A = £289.4m B = £165.8m C = £165.8m Total = 621m Equity of £599,000,000 Figure 11: Baroness Capital Structure for the 455p bid 38
  48. 48. BARONESSES USE OF A SCHEME OF ARRANGEMENT19 A scheme of arrangement (section 425 of the Companies Act 1985) is a court- based procedure that is announced in the same way as a conventional offer. However, instead of the target’s shareholders receiving an offer document the shareholders receive a scheme document instead. This scheme document contains notice of a shareholders’ meeting to approve the scheme and any other resolutions that required for its implementation. For example, resolutions are often required to approve the reduction in capital of the company. Schemes of arrangement have traditionally been considered as being a cumbersome and inflexible alternative to a conventional offer for companies that are being taken private. They have both advantages and disadvantages that make their use on balance make their use increasingly desirable in private equity transactions. Advantages A lower acceptance threshold is required to acquire the company. Under a conventional offer the bidder can only acquire the minority shares once the bid has been accepted by 90% of the shares. A scheme of arrangement has a much lower threshold of only 75% of the shares that vote at the meeting! It also less likely that the bidder will be left with having to placate the interests of minority shareholders. Stamp duty savings (of 0.5% of the offer value) on the acquisition of the targets shares can be made by adopting a cancellation scheme of arrangement. This 19 Compagnoli, M. and MacDougall, M. “UK switches on to schemes of arrangement: 2005 Guide to Private Equity” International Financial Law Review, Vol. 24, p72-75 39
  49. 49. involves the cancellation of all shares in the target by a reduction in the targets capital, followed by an issue of new shares to the bidder. Share options are triggered with a conventional offer that allows minority shareholders to exist post the transaction. If a scheme is used this problem can be negated as these share options will be triggered at the moment the scheme becomes effective. Under a conventional offer, the bank has a higher degree of financial risk because the bank can avoid any risk that the bidder will not wholly own the target and that this situation will occur more quickly. Under a scheme of arrangement debt can be secured on the assets of the target immediately after the scheme has become effective. Disadvantages The scheme of arrangement is a court based procedure and is subject to the timetable of the court. In contrast, a conventional offer requires only the majority acceptance of shareholders to accept the deal in order for the bidder to obtain control. In order for the Baroness Retail Consortium to gain control of Debenhams they needed to gain the approval of 70% of the voting stock of the company. On the day of the approval of the scheme of arrangement the major shareholders were Prudential (12.5% of the voting shares), Schroder Investment Management Ltd. (11.51% of the voting shares), and CGNU plc. (4.79% of the voting shares). Together, these companies represented 41% of the votes needed to pass the scheme of arrangement if all shares were voted. Their acceptance of the deal was critical to the scheme’s approval. 40
  50. 50. Market purchases prior to the shareholders meeting are excluded from the shares that are able to vote on acceptance of the bid. Such purchases are often at a lower price than the final bid price and allow the bidder to be more confident that their bid will be accepted. However, should the bid fail the bidder will not be left with shares in the company that would need to sell at a potential loss. It is more difficult to obtain irrevocable undertakings from shareholders to accept the bid prior to the shareholder meeting that accepts the scheme. There are complex legal issues that arise regarding potentially different classes of shares. Conclusion It is now common for banks, when arranging finance, to provide loan documentation with the transaction structured as a scheme of arrangement and as a conventional bid. During hostile or competitive bids conventional offers provide a higher degree of flexibility for the target to achieve a higher price. Once the bid has been accepted or if the bid is friendly and uncompetitive the bid can revert to a scheme of arrangement. Such a structuring of the deal has a number of advantages for private equity transactions. This was evidential in the take-private of Debenhams by the Baroness Retail Consortium. Latest time for lodging blue forms of proxy for the Court Meeting 11:00 am on 8 November 2003 Latest time to lodge pink forms for the Debenhams EGM 11:15am on 8 November Voting record time 6:00 pm on 8 November Court Meeting 11:00 am on 10 November Debenhams EGM 11:15 on 10 November 41
  51. 51. First Hearing Date (to sanction the Scheme) 28 November Hearing Record Time 6:00 pm on 1 December Second Hearing Date (to sanction the reduction of capital) 2 December Last day of dealings in Debenhams Shares 3 December Scheme Record Time 6:00 pm on 3 December Effective Date of the Scheme 4 December Delisting of Debenhams Shares 7:30 pm on December 5th Latest date for dispatch of cheques 18 December Table 3: Debenhams scheme of arrangement, expected timetable of principal events, 3rd November 2003 PERMIRA’S CONSORTIUM STARTS TO DISSINTEGRATE After Baroness had tabled the £4.55 bid for Debenhams there was disagreement in the Laragrove consortium about how high they could go without overpaying. Ultimately, Laragrove had a different (and lower value) view about Debenhams prospects. This differential view arose from a different view about the performance of the retail sector in the UK and the performance of the management team. 42
  52. 52. Permira was relying on the existing management team, whereas Baroness was relying on a new management team. Goldman Sachs had the most conservative view of Debenhams prospects and began to have cold feet. As the Laragrove team and bid began to waiver, Baroness strengthened its team by recruiting Merrill Lynch Private Equity. Baroness then took the unusual decision to up its bid to £4.75. Philippe explained this rational as follows: “We knew we had to move fast. We were starting to hear that Permira was trying to get more banks on board to put in a higher offer. It’s not easy to submit a bid over your own, but we felt their consortium was starting to waiver, and we went in with the new bid when we felt we had the best advantage.”20 THE SECOND AND FINAL BARONESS WINNING BID The Revised Baroness Bid The revised bid of £4.77 was 4.8% higher than the previous high Baroness bid and proved to be the difference between the consortiums bids and at a bid level that provided the transaction with a very good expected return on expected risk21 . 20 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 21 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 43
  53. 53. Funds advised by TPG (37.9%) Funds advised by CVC (37.9%) Funds advised by MLGPE (15.4%) Management (8.8%) Baroness Group LP Baroness Group Holdings BF VI Baroness Retail Ltd. Debenhams Ltd. Senior Credit Facility Term £571m Revolver £125m Baroness Holdings UK BF I BF II BF IV BF III BF V Mezzanine Facility £325m Bridge Facility £354.7m Deep Discounted Bonds A = £289.4m B = £165.8m C = £165.8m Total = 621m Equity of £607,534,661 Funds advised by TPG (37.9%) Funds advised by CVC (37.9%) Funds advised by MLGPE (15.4%) Management (8.8%) Baroness Group LP Baroness Group Holdings BF VI Baroness Retail Ltd. Debenhams Ltd. Senior Credit Facility Term £571m Revolver £125m Baroness Holdings UK BF I BF II BF IV BF III BF V Mezzanine Facility £325m Bridge Facility £354.7m Deep Discounted Bonds A = £289.4m B = £165.8m C = £165.8m Total = 621m Equity of £607,534,661 Figure 12: Baroness Capital Structure for the 477p bid 44
  54. 54. The Financing of the Debenhams Winning Bid The financing structure of the winning £4.77 bid was nearly identical to the previous £4.55 bid by Baroness. The new bid required an additional £7.5m of equity from the consortium in order to maintain the same leverage ratio of ~67%. The remainder was financed through an increase of £25m in the mezzanine facility and £5m in the term portion of the Senior Credit Facility. Transaction Sources and Uses Baroness committed £608 million of equity to the purchase of Debenhams. The transaction had an enterprise value of £1868 million with additional costs of £40 million incurred. This represents a leverage ratio of 67%. Sources Uses Term loan - A 289.4 Purchased equity1 1740 Term loan - B 165.8 Debt refinanced2 128 Term loan - C 165.8 Other3 40 Deep discount bonds 606.3 Bridge facility 354.7 Mezzanine facility 325.0 Ordinary equity 1.0 Total 1908 1908 Table 4: 2003 Acquisition: Transaction Sources and Uses (£m) Notes 1. Baroness Retail Consortium paid £4.7 per share. At 11:15am on the 10th November, 2003 the scheme of arrangement was approved. At this time there were 370,180,593 issued shares. This represents a purchased equity value of £1.74bn. 45
  55. 55. 46 2. On the 30P th P August 2003, Debenhams had £127.8m of net debt outstanding. This figure represents an estimate of the net debt outstanding at the time of the transaction. 3. The remainder is expected to consist primarily of transaction fees relating to the transaction and variation in the amount of the net debt outstanding. Interest Rate Risk Mitigation Plan Hedging contracts were entered into that would protect a substantial portion of the interest costs of the debt used to finance the acquisition. It was the intention of Baroness to refinance most (if not all) of the acquisition debt within a short timeframe after the acquisition. So variable rate debt and hedging contracts were used to mitigate exchange rate risk rather than the use of fixed interest rate debt. THE TRANSACTION PREMIUM PAID BY BARONESS The 2003 Acquisition price paid by Baroness was far in excess of the net asset value of Debenhams and represented a substantial premium to the NAV and the pre-offer and alternative offer prices for Debenhams. The stock price for Debenhams is charted in HTUAppendix A: Pre-2003 Acquisition Stock PriceUTH from the 9P th P May 2003, which was the last closing price before the announcement of a bid by Laragrove, too the 4P th P December, which was the last closing price before Debenhams shares were delisted from the London Stock Exchange. Baroness Retail was required to pay the following premiums to acquire Debenhams: The final Laragrove bid price: U10.6 percent higherU than the £4.25 price per share announced by Laragrove on the 29P th P July 2003.
  56. 56. 47 The pre-bid speculation price: U83.6 percent higherU than the £2.56 closing price per share on the 8P th P April 2003. This was the last closing price prior to the announcement of a possible offer for Selfridges plc. This announcement started speculation that Debenhams would also be made an offer. The last business day before Laragrove’s first offer on the 12P th P May: U42.0 percent higherU that the May 9P th P 2003 closing price of £3.31 per share. The six-month average closing price prior to bid speculation: U66.6 percent higherU than the average six-month closing price prior to May 9P th P, 2003 of £2.82 per share. The lowest closing price in the six-month period prior to bid speculation: U87.3 percent higherU than the lowest price paid per share of £2.51 in the six-month period prior to bid speculation.
  57. 57. Figure 13: Nectar Rewards Partner 48
  58. 58. C h a p t e r V I : B a r o n e s s e s I n v e s t m e n t i n D e b e n h a m s FINANCING ACTIVITIES DURING PRIVATE OWNERSHIP Summary The financing activities during public ownership where designed to accomplish several aims. The first was to release quasi dividends to Baroness in the form of cash. The second aim was to replace expensive debt with less expensive debt (Appendix E: Effective Interest Rates). Finally, the debt structure of the business was altered to move debt away from assets, as was the case at acquisition, to the group level in order to prepare the company for an eventual IPO (Appendix D: Funding Debt – UK GAAP). This would allow Baroness to achieve an exit on their investment. These financing activities are described below. Pre-Take Private Pre take-private, Debenhams debt included only bank overdrafts and lease obligations. These totaled only £146m at the 30th August 2003. 4th December 2003: Acquisition Financing Please see section on financing the winning bid Chapter V: How Baroness Won The Bid: The Second and Final Baroness Winning Bid: The Financing of the Debenhams Winning Bid) Immediate Post Acquisition Financing Post acquisition financing was concerned chiefly with refinancing higher interest rate bridge and mezzanine facilities with mortgage and high yield facilities respectively. In total over half of the acquisition debt, ~£700m, was refinanced out of a total acquisition debt of ~£1.3bn. These actions marginally reduced the 49
  59. 59. effective interest rate of the debt used to acquire Debenhams and moved debt further away from Debenhams Ltd. April 23rd 2004: Refinance of Bridge with a Mortgage Facility The bridge facility, at an interest rate of 6.5%, was an interim facility and was refinanced by a mortgage on properties held by BF Properties (No. 3) Ltd. The facility was due in 2011 and has an effective interest rate based on LIBOR of 6.5% 2004: Refinance of Mezzanine Facility with a High Yield Facility The £325m mezzanine facility at an interest rate of 10.5% was an expensive facility that constituted one of the principal components of the 2003 acquisition financing. This was refinanced by a high yield term facility of £209m at an interest rate of 10.5% due in 2012 and a 172 million euro facility at 9.5% also due in 2012. The costs of this refinance were also expensed immediately. Balance Sheet at the 28th August 2004 Both the mortgage facility, although secured against freehold and long leasehold assets, and the high yield senior note facility ensured that debt was moved away from the core Debenhams business and towards Baroness Holding UK Ltd. See (Figure 15: Capital Structure at the 28th August 2004). This prepared Debenhams for an eventual IPO and made it easier for Baroness to receive a dividend in a tax efficient manner from Debenhams. Because the senior note debt was moved further away from the cash generation of Debenhams Ltd. The banks were taking on additional risk in issuing this debt. Baroness was able to achieve the mezzanine refinancing due an improvement in the cash generation capacity of the Debenhams business. This was the result of the first stage in the Baroness plan to improve the financial and operational performance of the Debenhams business. 50
  60. 60. Debenhams managed its exchange rate risk by holding a number of interest rate swaps at between 4.9% and 6.0% interest to a total value of £939m. 51
  61. 61. Funds advised by TPG Funds advised by CVC Funds advised by MLGPE Management Baroness Holdings UK Ltd. Intermediate Parent Companies BF III Issuer (Debenhams Finance Holdings plc) Baroness Retail Ltd. Senior Notes Debenhams Ltd. Other Subsidiaries Debenhams Card Handling Services Debenhams Gift Vouchers Ltd. Debenhams Property Ltd. Debenhams Retail plc Senior Credit Facility Mortgage Facility Baroness Group LP Deep Discounted Bonds Funds advised by TPG Funds advised by CVC Funds advised by MLGPE Management Baroness Holdings UK Ltd. Intermediate Parent Companies BF III Issuer (Debenhams Finance Holdings plc) Baroness Retail Ltd. Senior Notes Debenhams Ltd. Other Subsidiaries Debenhams Card Handling Services Debenhams Gift Vouchers Ltd. Debenhams Property Ltd. Debenhams Retail plc Senior Credit Facility Mortgage Facility Baroness Group LP Deep Discounted Bonds Figure 14: Capital Structure at the 28th August 52
  62. 62. The Dividend Payment and Preparing for an IPO February 22nd 2005: The British Land Sale-and-Leaseback Transaction Debenhams management had already separated the real estate assets from the operating company. In February 2005, Baroness completed a sale-and-leaseback of 23 freehold and long-leasehold Debenhams stores to British Land. Profits from the £495m deal were used to pay down debt (the mortgage facility), formed part of a dividend that was paid to Baroness alter in the year, and provided cash for Debenhams to expand. May 16th – June 23rd 2005: The 2005 Acquisition and Refinancing The 2005 Acquisition and refinancing was a vehicle for Baroness to recover a £1.3bn dividend payment from Debenhams. £1,196m was paid to the sponsor consortium and £84m was paid to management and employees. Effectively a new leveraged buyout occurred whereby the old company, Baroness Group Limited Partnership was dissolved and replaced by a new company Debenhams Retail Holdings Limited. £589.2m of equity was invested in the same proportions as before by the consortium and £1.82bn of senior term loan debt was raised. This debt was held further away from the cash flows generated by Debenhams Ltd. By Debenhams Retail holdings Limited, which refinanced new loan, notes held Baroness Group Holdings. These loan notes were no longer needed as this refinancing not only delivered a £1.3bn dividend payment but also gave the group the necessary capital structure to prepare for an eventual IPO. Freshfields Bruckhaus Deringer advised Debenhams on the £2.05 billion refinancing of its third-party and shareholder debt and on the related corporate restructuring22 . CSFB, Citigroup, Merrill Lynch and Morgan Stanley acted as lead 22 “Banking and Restructuring” International Financial Law Review, Vol. 24 Issue 7 (July 2005), 13-13 53
  63. 63. arrangers for the syndicated loan facilities23 . Shearman and Sterling advised the lead arrangers24 . The market had some concerns about the amount of cash that Baroness was taking out of Debenhams. Their concerns regarding the leverage and pricing of the refinancing are detailed below in a European Venture Capital Journal article of the time. “Leverage is aggressive for a company operating in the notoriously difficult UK retail market and some lenders have expressed concern that second lien pricing is too fine, especially as the recapitalisation will see £800m of equity removed from the company.”25 The Balance Sheet at the 3rd September 2005is shown in Figure 24: Capital Structure at the 3rd September 2005. 23 “Banking and Restructuring” International Financial Law Review, Vol. 24 Issue 7 (July 2005), 13-13 24 “Banking and Restructuring” International Financial Law Review, Vol. 24 Issue 7 (July 2005), 13-13 25 M. Brizard, “REFINANCINGS” European Venture Capital Journal, 123 (June 2005), p25-26 54
  64. 64. Funds advised by TPG (37.9%) Funds advised by CVC (37.9%) Funds advised by MLGPE (15.4%) Management (8.8%) Debenhams Retail Holdings Limited Baroness Group Holdings Intermediate Companies Baroness Retail Ltd. Debenhams Ltd. Baroness Holdings UK Loan Notes B = £50.1m C = £22.3m (BELP) Total = 589.2m Equity of £589.2m Senior Term Loan £1.82bn Funds advised by TPG (37.9%) Funds advised by CVC (37.9%) Funds advised by MLGPE (15.4%) Management (8.8%) Debenhams Retail Holdings Limited Baroness Group Holdings Intermediate Companies Baroness Retail Ltd. Debenhams Ltd. Baroness Holdings UK Loan Notes B = £50.1m C = £22.3m (BELP) Total = 589.2m Equity of £589.2m Senior Term Loan £1.82bn Figure 15: Capital Structure at the 3rd September 2005 Final Preparations for an IPO April 19th 2006: The ‘New Credit Agreement’ Once IPO’ed Debenhams would become a FTSE250 company. FTSE250 companies reach a different investor base and so Debenhams was able to secure better funding levels from the banks prior to its IPO. The New Credit Agreement provided senior facilities up to £1,350m. This consisted of a £1,050m 55
  65. 65. term loan and a £300m multi-currency revolving facility. “They hit the market with perfect timing to get as much from the debt as they could” [Brian Gray, Freshfields Partner26 ] The proceeds were intended to refinance the existing package of debt and included the early repayment of a second lien. The new credit agreement was entered into with The Royal Bank of Scotland, the Governor and Company of the Bank of Scotland, Lloyds TSB Bank, and Barclays Capital. The refinancing prepared Debenhams for a near term IPO by making sure that the loan documentation included sophisticated qualified public offering provisions. PERFORMANCE IMPROVEMENT The Baroness strategy is fundamentally a relatively simple and classic strategy: Baroness bought an underperforming business whose industry and business prospects were undervalued by the financial markets. Baroness immediately improved the operational effectiveness of the business and adjusted the portfolio of what was being sold to higher margin and higher growth segments whilst taking cost out of the business by reducing non-core activities, investments, and negotiation. These improvements then create new growth opportunities that were exploited through the use of cash flow generated from improvements. The result is a more profitable business that is valued at a higher multiple because of its improved prospects. By leveraging the equity investment higher returns were achieved than through the use of all equity financing. 26 Cushnie, L. “Debenhams’ return to the LSE ensures saga ends well for all” The Lawyer, Vol. 20 Issue 18 (8th May, 2006), 13-13 56
  66. 66. Baroness essentially set about transforming the operations of Debenhams. They did this by transforming Debenhams business model from a cost heavy ‘high- CAPEX, low-growth’ model to a more cost-efficient ‘high-growth, low-CAPEX’ model. This released cash to invest in growing the business. The next chapter will seek to expand on and quantify the sources of value that the Debenhams management team and Baroness created at Debenhams. 57
  67. 67. C h a p t e r V I I : T h e D e b e n h a m s I P O a n d T h e P e r f o r m a n c e o f t h e B u y o u t OPERATIONAL EQUITY RETURNS Sales Growth (£213m equity gain) Although the market declined between 2003 and 2005, from £13.8bn to £13.3bn27 (see figure below), a 3.6% reduction. Debenhams was able to increase its market share of the UK department store market from 15.3% to 18.6% during the same period28 . Market share gains accounted for a £213m increase in the equity value of Debenhams over the period of the transaction (see Appendix H: Source of Deal Value Creation) and produced a 35% return on equity for the sponsor consortium. A number of initiatives were pursued in order to achieve these impressive gains. 11.8 12.9 12.312.112.1 12.8 13.413.813.713.3 11 11 12 12 13 13 14 14 1996 1997 1998 1999 2000 2001 2002 2003 20042005E 0% 5% 10% 15% 20% Market Value (£Bn) Debenhams Market Share Figure 16: Debenhams: UK Department Store Sales (Source: Company data) 27 Debenhams plc IPO Offer Prospectus (Citigroup, 4th May 2006), p22 28 Debenhams plc IPO Offer Prospectus (Citigroup, 4th May 2006), p22 58
  68. 68. 2 4 8 13 83 143 208 266 324 450 0 100 200 300 400 500 1996/97 1997/98 1998/99 1999/00 2000/01 2001/02 2002/03 2003/04 2004/05 Target Value (£M) Figure 17: Debenhams: Designers at Debenhams Sales (Source: Company data) 75 76 76 74 72 70 75 25 24 24 26 28 30 25 2000 2001 2002 2003 2004 2005 Target Own Bought Concessions Figure 18: Debenhams: Bought versus Concessions Mix (Source: Company data) 59
  69. 69. Figure 19: Debenhams 2006 Brand Mix (Source: Company data) Figure 20: Debenhams Brands Appeal versus the competition 60
  70. 70. Other Initiatives – Beating the sector average Debenhams has actively promoted and enhanced the position of its own brands and has increased its customer differentiation versus its competitors (Figure 20: Debenhams Brands Appeal versus the competition). This along with a logical extension of product sold through its designer range (and additional designers) has enabled and increase in sales performance. International Expansion The opportunity to expand internationally was first presented to Debenhams by the long-established, Kuwait-based Alshaya Group. The Alshaya Group is a company with a wealth of experience in the retail sector of the Middle East and an understanding of western retailing.29 In 2001, the Alshaya Group was operating four hundred franchise outlets in seven Middle Eastern countries and was a leading operator of international brands. They had franchise agreements with Mothercare, Liz Claiborne, Next, River Island, Etam and Clarie’s Accessories.30 Continued partnership with companies such as the Alshaya group drives top-line growth and moves the business down the experience curve through creating an increased bargaining power vis-à-vis suppliers. Margin Improvement (£439m equity gain) Reduction in Overhead and Increased Store Efficiency Head office overhead reduced is likely to have been reduced as a proportion of sales. Head office headcount has remained constant despite an increase in gross transaction value31 . 29 J. Glynis, “Taking Debenhams International,” European Retail Digest, Issue 36 (Dec2002), p22-25 30 “Exploring the Middle East as a Region of Retail Excellence conference proceedings,” World Class Retailing, 30-31 (October 2001) 31 Company data. 61
  71. 71. Store efficiency was increased through the achievement of improved lead times, flexing space to be responsive to changing customer fashions and by ensuring that high traffic floor space is used to sell higher margin product. Historically Debenhams was part of the Burton group and much of its floor space was devoted to selling those products, which was lower margin concession product. Selling a more profitable mix of products During private ownership, gross merchandise margin improved seventy basis points from 42.2% to 42.9%. This was achieved through improved space management in the stores, creating a differentiated and premium offering to the customer (Figure 20: Debenhams brand appeal versus the competition), by increasing the proportion of higher margin own brand rather than concession products32 (Figure 18: Debenhams: Bought versus Concessions Mix), and by increasing the mix of more profitable Designers at Debenhams sales (Figure 17: Debenhams: Designers at Debenhams Sales). Supply Chain Improvements 44.0% 47.7% 49.0% 49.3% 50.0% 671 579 434 380 260 40% 42% 44% 46% 48% 50% 52% 2001/02 2002/03 2003/04 2004/05 Target 0 200 400 600 800 Mix of Top 30 Number of Suppliers Figure 21: Debenhams Supply Chain Improvements 32 See Figure 18: Debenhams 2006 Brand Mix for a description of Debenhams major brands 62
  72. 72. The number of suppliers has fallen dramatically from 679 in 2002/03 to 380 in 2004/05. This has likely resulted in volume, transaction cost, distribution cost, and payment term savings. However, the mix of the top thirty suppliers has only increased from 47.7% to 49.3% during the same period. A consolidation of the supplier base imposes additional risk to the business. Reducing the number of smaller suppliers rather than increasing the concentration of the largest suppliers has mitigated supplier concentration risk on the business. A new distribution center has replaced several other smaller centers and can provide additional capacity for future growth. Sourcing from Low Cost Countries Debnhams sources most of its merchandise by value from low cost countries. It has adopted a sourcing strategy run on a country rather than supplier basis to protect itself from political and macro-economic risks. This strategy has kept its sourcing costs low. Far East 56%Europe 23% Turkey 10% Indian Region 6% Rest of World 5% Figure 22: Debenhams use of sourcing from low cost countries 63
  73. 73. Figure 23: Designers at Debenhams 64
  74. 74. Improved Targeting of Customers In October 2002, Debenhams joined a new loyalty card venture with non- competing brands Sainsbury’s, BP, and Barclaycard. An independent company, Loyalty Management UK, manages the venture. The take up of the scheme exceeded all expectations and by Spring 2003 there were 11mn33 active cards in use. Shared access to the customer database has provided Debenhams with more accurate customer information. This has enabled Debenhams to more effectively market itself and attract new customers. Consequently this has improved mix/pricing and has helped to drive Lfl sales increases. Cash Flow and Working Capital Improvements (£282m equity gain) Cash Flow and Working Capital improvements generated a £282m equity gain for the deal. Baroness was very effective in this area and acted very quickly to achieve these gains. When Baroness took Debenhams private, the new management team found that 7.2%34 of stock was terminal (Terminal stock is stock that has reached the end of its selling season). Indeed, stock was lying around in non-shop floor areas of stores gathering dust. The new management managed to achieve a five hundred basis point reduction in terminal stock to only 2.2%35 at the end of the 2005 financial year. This was achieved through an immediate fire sale that cleared this stock and generated some immediate cash for the business36 . 33 Mintel, Department and Variety Store Retailing – UK (Retail Intelligence, June 2003), p84 34 Management Accounts 35 Management Accounts 36 Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group 65
  75. 75. Management also took action to increase average creditor days. During the same period average creditor days were more than doubled from 27 days to 60 days37 and had the effect of freeing both cash and working capital for the business. Initiatives such as those described had the effect of freeing up a substantial amount of working capital. Indeed before the take-private average working capital was £25m38 . At the end of the 2005 financial year average working capital was reduced by £145m to £(120)m39 . NON-OPERATIONAL EQUITY RETURNS The following presents a discussion of the non-operational equity returns for the Debenhams deal. It is worth considering that multiple expansion will contain an unknown proportion of gains that are caused by improved prospects in the Debenhams business. These gains are the result of operational improvement made by the Debenhams management team. British Land Transaction ($315m equity gain) This transaction provided a £315m (51% ROE) gain in the value of the transaction on £600m+ of property transferred to British Land40 . Any sale of property assets that are necessary to conduct business should be reflected in higher lease payments in future years. This should, all things being equal, reduce future expected cash flows and cancel out the money made on this gain. See limitations of value analysis later in this chapter. 37 Management Accounts 38 Management Accounts 39 Management Accounts 40 Management Accounts 66
  76. 76. Expenses (£421m equity gain) Expenses were incurred to incentivise management. At £221m these are much smaller than the operational value created in the business. Fees and expenses paid to lawyers, bankers, and consultants totaled £200m are cost of conducting a leveraged buyout. It would be easy to regard these as destroying value in a business. However, I regard them as cost in facilitating a step-level change in the performance of the Debenhams business. Whether, this could have been achieved under public ownership with appropriately designed incentives is questionable and is the subject of much debate in management literature. Multiple Expansion (£595m equity gain) Multiple expansion accounted for a £595m increase (97% ROE) in the equity value of Debenhams. It is unclear the extent to which the multiple expanded as a consequence of a rising market for buyouts. However, the Debenhams management team was successful at demonstrating improved growth prospects for the business. This has been achieved by creating new business sales growth opportunities by improving the economics of new Debenhams stores so that they can now be sited in smaller markets. These markets could not previously justify the capital expense of a new store. In addition, the Desire by Debenhams new store concept provides an exciting small store format that can tap new smaller markets. Reduced New Store CAPEX New store CAPEX has been a major success story for the Baroness team. Capital spending per square foot for new stores has decreased by 39.3% from £178 per sq ft to £108 per sq ft. This has been achieved by reengineering the process of investing in new stores. Debenhams states that this has allowed them to justify expansion into smaller markets that would have otherwise have been uneconomic. However, the difficulty of some of its major competitors such have 67
  77. 77. Alders, have allowed a large amount of store space to come onto the market at a lower cost than in the past. Whether this is included in the calculation of new store CAPEX is not clear and also makes comparisons across stores to benchmark performance all the more challenging. Desire by Debenhams Desire by Debenhams operates on a smaller 20,000 sq ft footprint and sells higher margin Debenhams products such as the Designers range, accessories, and cosmetics. The store is aimed squarely at women who want to purchase Debenhams products in their smaller local town. Such a concept, if successful, promises to increase sales per square foot and lower the cost base of the entire company through improved company buying power. However, with only three stores in operation at the time of the IPO, this new store concept is still in its early stages of proving its long-term viability. The case for multiple expansion has largely convinced the financial markets. However, in my mind the case is not so clear. I think that time will tell if new stores that have undergone the new CAPEX program require refurbishment earlier than before, if lease acquisition payments are included in new store CAPEX and if Desire is a hit. VALUE CREATED The result of the Debenhams management team and Baronesses strategy was an improvement in EBITDAR (EBITDA adjusted to include rent escalators from the British Land transaction) during the period of private ownership from 68
  78. 78. £218.1m to £378.8m41 (see Figure 19: Debenhams EBITDAR performance). This is a CAGR of 20.2%42. 218.1 254.2 318.0 378.8 12.0% 13.4% 15.2% 16.7% 0 50 100 150 200 250 300 350 400 2003 2004 2005 2006e 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% Adjusted EBITDA % of GTV Figure 24: Debenhams EBITDAR performance The operational improvements achieved in the business are impressive. £934m of value was created through improving the operational performance of the Debenhams business. £479m of value was created in non-operational performance improvements. This deal achieved a total increase in value of £1,413m. 41 Company data 42 Company data 69
  79. 79. THE IPO TRANSACTION AT £1.95 On the 4th May 2006, Debenhams returned to the London Stock Exchange. This partial exit (Baroness, management, and employees still held thirty eight percent of the equity in Debenhams post IPO) allowed Baroness to release a further £1.045bn in cash. Debenhams was very consistent in its financial outlook leading up to the IPO and stated a few weeks before the IPO that “The prospects for Debenhams' trading for the financial year ending August 2006 remain in line with management expectations.”43 Citigroup and Merrill Lynch were the joint global co-coordinators of the offer, while Citigroup, Merrill Lynch, Credit Suisse and Morgan Stanley were the joint book runners for the offer. P/E 12.8x 2006E analyst forecast of NI £131.2m Implied equity value £1,675m Analyst forecast of post IPO Net debt £1,200m Enterprise value £2,875m Primary issuance (includes fees) £700m Selldown at IPO £345m Total equity issuance at IPO £1,045m Free float post IPO 62% Implied value of initial investors equity at IPO price £975m Less Selldown at IPO (gross) £345m 43 Debenhams press release. 70
  80. 80. Holding post IPO £630m % Holding 38% Table 5: Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group DEAL ECONOMICS Sponsor Consort um (4)i Management and Employees (2) Initial Investment (5th December 2003) £602m £6m % Of company 86% 14% Dividends at Recap (16th May 2005) £1,196m £84m (3) Share of Selldown at IPO (5th May 2006) £306m Value of equity still invested (5th May 2006) £529m % Of company 32% Fees (5th May 2006) £19m Total Value from Investment (1) £2,012m Multiple of Initial Investment 3.3x Internal Rate of Return on Investment (5) 98.0% Table 6: Interviews with Philippe Costeletos, lead buyout partner from the Texas Pacific Group Notes 71
  81. 81. 1. This figure is net of IPO fees and includes the value of remaining stock. 2. Includes senior management and the Debenhams Retail Employee Trust. 3. Includes cash and Debenhams loan notes. 4. There were press reports of an immediate £130m dividend paid to Baroness post take-private. However, this amount is not included in the figures provided by the Texas Pacific Group. 5. Calculated using the XIRR function in Microsoft Excel. This function discounts the cash flows on the exact date that they occurred. The Baroness Retail buyout of Debenhams returned the sponsor consortium a 3.3x return on equity to investors at the IPO. However, at the time of the IPO, twenty six percent of the total value from the investment was not in cash and was in the form of Debenhams stock. This left this return vulnerable to fluctuations in the stock price and was not as liquid a return as cash. Management and employees total value from their investment of £6m was £221m. The internal rate of return of 98.0% is much higher than a private equity firm’s normal requirement of at least 35%. 2.5x returns were achieved through operational improvements to the Debenhams business. The sources of these gains are presented in Appendix H: Source of Deal Value Creation. LIMITATION OF VALUE ANALYSIS General Such an analysis is dependent upon the information that is available to analyze decisions taken by management and their results. No attempts has been made to 72
  82. 82. separate the results of actions taken by past management and either been enjoyed or regretted by the buyout management team. In addition, short-term measures that are presented as savings from long-term trends (and therefore value enhancing) could prove to be false economies. And projections of future performance based on one or two years of running may prove to be too optimistic. These risks are inherent in such an analysis. Return on Capital Employed is a better measure of value creation The value analysis does not consider the return on capital employed in the business. Over the course of private ownership by Baroness, considerable capital was released from the business on a sale and leaseback basis. In order to get a true measure of the capital employed in the business, the present value of future lease payments needs to be recognized as a fixed asset in order to arrive at a true and comparable value of the capital employed in the business. Capitalizing Leases to arrive at ROCE 2003 2004 2005 Capitalised leases (IFRS) na na 3789.5 Operating leases (GAAP) 55.3 64.8 107.2 Scaling factor 52% 60% 100% Estimated Capitalized Leases 1954.8 2290.7 3789.5 Capital Employed excluding goodwill 852.1 1015.8 536.5 CE excl. GW and incl. Est. Cap. Leases 2807 3306 4326 Gross Sales 1810 1903 2087 EBITDA/GS 12.0% 13.3% 14.7% GS/CE 0.64 0.58 0.48 ROCE 7.8% 7.7% 7.1% Figure 25: Estimated ROCE analysis 73
  83. 83. The information needed to conduct this analysis is not included in sufficient detail for me to be able to conduct a thorough analysis. For example, note 29 in the IFRS statements details future lease commitments for 2005. However, figures for 2003 and 2004 are not available under IFRS. The GAAP statements in note 27 provide summary operating lease commitments for 2003, 2004, and 2005. However, using the GAAP figures as a scaling factor to arrive at a rough figure for capitalized lease costs for other years could be misleading because of the size and long-term nature of the deal vis-à-vis the other leases. In addition, freehold properties would need to be removed from tangible fixed assets to arrive at a better figure for capital employed in the business. Taking a rough figure using a scaling factor for leases and not including goodwill, ignoring property price rises, or removing freehold fixed assets, capital employed in the business increased from £2,807m in 2003 to £4,326m in 2005. Value would have been destroyed, as ROCE would have declined over the period from 7.8% to 7.1%. In effect, the gains from operational improvements would have been negated by the increase in the capital employed in the transaction from the British Land transaction (see Appendix I: Debenhams Estimated ROCE Analysis). The results from this analysis however are not conclusive and more information is required to obtain a more accurate figure for capitalized lease costs. Ignoring the British Land Transaction Ignoring the impact of the British Land transaction, I can proceed as follows. Asset Turnover: Excluding property transaction, I believe that through working capital reduction and reductions in the CAPEX required for new and refurbished stores and ignoring goodwill, that asset turnover should have increased over the period of private ownership. 74
  84. 84. EBITDA Margin: During the period of private ownership, adjusted EBITDA margin increased from 12.0% by three hundred and eighty basis points to 15.8%44 . From this analysis, I conclude that (excluding the property transaction) return on capital employed in the Debenhams business has risen during the period of private ownership. 44 Management Accounts 75

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